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Sunday, Nov 8, 2009
You're not alone in doing this, but I'm disappointed to see yet another discussion of complex financial instruments reduced to an analogy with betting. This simply isn't useful in helping people understand what's truly going on. Most people have a subconscious understanding of betting as something dangerous, kind of shady, and inherently extremely risky (and often fixed). You're invoking all of that by using the analogy, even if it isn't valid.
Unless you believe all investing is equivalent to betting on the Super Bowl, this isn't a good way of explaining the relationship between risk and reward and how that's obfuscated.
These financial instruments are accumulations of real sources of income. At the bottom are a bunch of mortgages getting (hopefully) regular interest payments. It makes perfect sense to aggregate them and sell them. It's entirely reasonable to have the higher-risk mortgages pay higher interest rates in exchange for the increased risk. This is how financial systems work. It's no more betting than buying stocks is betting. It's just more complicated.
To make a sweeping generalization, markets go wrong in two ways: people ignore risk, or people lie about risk. When people ignore risk, they pursue the highest-paying investments, ignoring that there's a reason why they're high-paying. When people lie about risk, they deceive people into thinking an investment with greater gain potential has the same risk level as some traditional investment with less gain potential, and thereby draw money into their investment. That's the part of this story to focus on. Were people just ignoring the risk, putting too much faith in the idea that not all the mortgages will fail at once and hence the senior securities will be safe? Or were people lying?
Talking about betting does nothing to add clarity.
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